WHY ARE VARIABLE ANNUITIES GROWING IN POPULARITY?
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UPDATED: Aug 19, 2020
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As the baby boomer generation of Americans born after World War II move into their retirement years they have created a large market demand for products that can supply an income they cannot outlive. It has been projected that 90 million U.S. consumers will reach retirement in the next 10 years. The baby boomers have financial assets earmarked for retirement estimated to be more than $12 trillion with several trillion more in other countries.
During their peak earning years these boomers accumulated this retirement money largely in mutual fund, stock and bank accounts. Retiring workers may not have defined benefits pensions plans but often have substantial assets in 401(k), IRA and other accounts that will be used for income during retirement. Insurers have experience in providing income for life through fixed and variable annuities. So insurance company marketers have been noticing this large stash of cash and are looking at ways to make their offerings more attractive to consumers and to make buyers aware of what is available.
Though the U.S. is the largest market at present, Japan and other countries are also becoming good markets for variable annuities.
The variable annuity products, where the value is based on stocks or mutual fund performance, have proven to be especially popular. Sales dipped in the beginning of this decade, but variable annuity sales have been experiencing brisk growth since 2003. Sales of variable annuities were $153 billion in 2006, up from $133 billion in 2005. In all, investors in the U.S. have more than $1.35 trillion in variable annuity accounts. This is more than 50% higher than 5 years ago. In addition to positive stock market performance during the last several years, which makes the returns more appealing, the companies have tweaked the products by adding popular guarantees which are being marketed under the name “living benefits.”
About two-thirds of variable annuity sales during the first half of 2006 included living benefits riders. By contrast, fixed annuity sales have been substantially less (roughly one half as large in 2006) and trending down.
Furthermore, insurance companies have tried to end abuses of recent years that have sometimes tarnished the variable annuity industry as when inappropriate sales techniques were used or sales were made to customers who should not have been customers (because of advanced age or other factors) for the product, thus resulting in sanctions from regulators. High fees have been an additional negative for some variable annuity products. High fees reduce the return to the customer. Insurers say they have been lowering fees.
While the basic idea of an annuity is quite simple — you give the insurance company money and it guarantees you a stream of payments which begin immediately or at some future time –- there are many variations on this idea that can make the product seem bewilderingly complex.
In the U.S. a variable annuity, essentially, puts payments in a tax-deferred investment account. At retirement, the customer can take the money out of the account or turn it into a lifetime income.
Insurers sell annuities through various sales methods. Sales of annuities in 2006 (according to LIMRA) came through career agents (20%), independent agents (19%), financial planners and independent broker-dealers (19%), banks (17%), stockbrokers (14%), direct response (7%) and other distribution methods (4%). For variable annuities, the latest numbers come from 2005 (from NAVA and Morningstar) and captive agents (35%), independent NASD firms (31%), banks and credit unions (13%), New York wirehouses (10%), regular investment firms (10%) and direct response (1%).
The living benefits that have enhanced the popularity of annuities in the last few years are basically guarantees that the customer will get some specified minimum level of return or a minimum of some specified number of payments. The three basic types of living benefits are:
Guaranteed Minimum Income – this benefit is for people who want to accumulate money in an annuity and then expect to take the proceeds as an income stream, rather than withdrawing the cash. Someone who is certain they do not want the income payments, would be paying unnecessary fees for a benefit they will not use if they selected this option. If you take this option, you get to decide at some predetermined time (often 10 years into the contract) how much the minimum payments of lifetime checks will be.
If your investments are doing well you can annuitize a larger amount than the minimum, otherwise you can exercise this option to provide a floor to your lifetime income.
Guaranteed Minimum Withdrawal – this is also for people who do not plan to annuitize their accumulated investment. One version of this benefit allows you to withdraw a set amount annually (often 7%) for a specified number of years. After that period of years the payments stop and, if your investments have done well and the account still has cash left, you can take it in a lump sum or an income for life. The lifetime version of this benefit provides for withdrawals limited to about 4% or 5% of the initial investment each year. The payments continue for life even after the original investment amount has been paid out and regardless of the actual account value. For example a $100,000 investment with a 5% withdrawal would pay the annuitant $5000 per year as long as he or she lives even after 20 years and even if the investment results have been subpar.
Guaranteed accumulation – is less popular than the other living benefits because it is really designed for investors who do not want to take any risk of loss but nonetheless feel the need to try to get some gains from stock market appreciation. This benefit guarantees that you will recoup at least as much as you invested after some period (often 7 to 10 years) even if your investments falter. For additional fees you can guarantee a gain of 3% or 5% per year in addition to your initial investment. If your investments outperform the guaranteed amount you get the higher account value. If not, you get the guaranteed amount.
It should be apparent that these are desirable options for certain investors, but the investor needs to consider carefully their investment needs and risk tolerance in the context of their personal situation. Buying an option that you are unlikely to use is a wasteful misallocation of your investment capital to needless fees. Looking at it from the insurance company’s point of view it should be apparent that the guarantees must be carefully calculated or the insurer may be unable to honor them. So the investor should be careful to buy these products only from companies that are financially sound.
How do you know if variable annuities are right for you? Consider a few questions before purchasing any annuity.
When do you expect to retire?
What are your goals for retirement?
What would an annuity do to help you reach your retirement goals? (supplement your income, provide “living benefits,” annuity death benefits, etc.)
Would you need to get access to the money in the annuity? (consider surrender charges, if any)
What is your financial plan?
Have you discussed your plans with your financial advisor (or estate advisor, or tax advisor)?
Some advisors suggest that you limit your contribution to an annuity to about one third of your retirement funds.
Be aware that regulators have warned that variable annuities are generally not suitable for retirees because of the holding period which may be a decade or longer during which surrender fees of 10% or more may be charged. For seniors immediate annuities (which begin paying within a year) are usually more appropriate. Variable annuities are more appropriate for people still in the work force who expect to retire in 10 to 15 years and are already making maximum contributions to their 401(k) and IRA accounts.
Annuities grow tax-deferred but the profits are taxed at ordinary rates at withdrawal. By contrast, stock and mutual fund investments may be taxed at lower capital gains rates.
Make sure that you understand what you are buying and what fees you will incur. Do not pay for benefits that you do not need.
It is important to understand that all financial products (including “no-load” investments) have fees. Anyone considering a variable annuity should be sure to understand the fees they will be charged. Customers usually pay commissions plus additional fees to withdraw money early. Morningstar says fees average nearly 2.5% or about 1% higher than the charge for the average U.S. stock mutual fund. Fees can have a substantial impact on the return of the investment. Three typical fees for variable annuities include:
Investment Management Fee – this covers management of the funds in the variable annuity’s investment portfolio. Typically, this fee is about 0.96% of the amount invested.
Insurance Charge – this is for mortality and expenses and is typically about 1.25% of the average value of the amount invested. These fees relate to the lifetime income payout and the death benefit. Other charges may apply for options selected by the customer. Administrative fees of about $30 per year are typically charged in addition.
Surrender Charge – this is for early withdrawal of funds. Often the charge is about 5-7% of the amount withdrawn. Often, the charge reduces to zero after the funds have been in the account for a period of 5 to 7 years. Some contracts being offered today do not have a surrender charge.
In addition to these fees, brokers often charge a commission to the company issuing the annuity. The company will usually recoup the commission through the fees mentioned above.
According to VARDS and Morningstar the top writers of variable annuities (by new sales) in 2006 were:
(sales are in millions of dollars)
Teachers Insurance and Annuity Association – $13,671
John Hancock Life Insurance – $5,452
Jackson National life – $4,414
Variable Life Insurance Company – $4,398
Pacific Life – $4,182
RiverSource Life – $3,478